Abstract : The increased reluctance of big banks to use their balance sheets for intermediation of safer assets is caused by risk-insensitive forms of capital requirements, such as the leverage-ratio rule, and by increased funding costs that have nothing to do with regulatory capital requirements. Now that the creditors of big banks are less likely to be bailed out with government capital, they are requiring much higher credit spreads. Using models and evidence, I show that bank credit spreads set a lower bound on the extra return (above and beyond the fair market return) that banks must earn on their trading activities to compensate their shareholders for use of balance sheet space.

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